10. Risk Factors Relating to Islamic Mode of Investment Introduction All Islamic banks and Islamic branches of conventional banking are required to measure and apply capital charges against credit, market and operational risk. Features of Islamic Mode of Investment Islamic modes of investments are asset-based. Gross return of these investments is the spread between the cost of the asset to the bank and the amount that can be recovered from selling or leasing it. Some investments can be categorized as equity participation and based on profit and loss sharing. Quards are beneficence financing based on service charge only. Bai-Murabaha : The seller informs the buyer of his cost of acquiring a specified product; then the profit margin (or mark up) is negotiated between the buyer and the seller. The total cost is usually paid in installments. Bai-Salam: Purchase with deferred delivery. The buyer pays the seller the full negotiated price of a product that the seller promises to deliver at a future date. This mode only applies products whose quality and quantity can be fully specified at the time the contact is made. Usually, it applies to agricultural or manufactured product. Bai-Istisna: The Istisna’a sale is a contract in which the price is paid in advance at the time of the contract and the objects of sale is manufactured and delivered later. The majority of the jurists consider Istisna’a as one of the division of ‘Salam Sale’. Bai Muajjal: Deferred payment sales. The seller can sell a product on the basis of a deferred payment in installments or in a lump sum payment. The price of the product Risk Factors Relating to Islamic Mode of Investment………………………………….55 is agreed upon between the buyers and the seller at the same time of the sale and cannot include any charge for deferring payments. Ijārah: Leasing or lease purchase: A party leases a particular product for a specific sum and a specific period of time. In the case of a lease purchase, cash payment includes a portion that goes towards the final purchase and transfer of ownership of the product. Higher Purchase under Sirkatul Melk : In this mode of investment Bank and borrower on the basis of contract purchase transport, machine & plant, building, apartment etc. Borrower uses it on the basis of rent and repays part of principal amount of bank. Thus borrower becomes owner of the property. In this process borrower deposit his equity to bank. Borrower pay the agreed rent and after full repayment bank handover the title to the borrower. Quards al-Hasana: Beneficence loans. These are zero return loans that the Islamic principles exhort Muslims to make ‘to those who need them’. Banks are allowed to charge the borrowers a service charge to cover the administrative expenses of handling the loan, provided that the charge is not related to the amount or maturity of the loan. Jo’alah: Service charge. A party under take to pay another party a specified amount of money as a fee for rendering a specified service in accordance to the terms of the contract stipulated between the two parties. This mode usually applies to transactions such as consultations, and professional services, fund placements, and trust services. Mushārakah: Equity participation contract. The bank is not the sole provider of funds to finance a project. Two or more partners contribute to the joint capital of an investment. Profit and losses are shared strictly in relation to the respective capital contributions. The kind of contract is usually employed to finance long-term projects. Risk Factors Relating to Islamic Mode of Investment………………………………….56 Mudārabah : Trustee finance contract. Under this kind of contract, the bank provides the entire capital needed for financing a project, while the entrepreneur offers his labor and expertise. The profit from the project is shared between the bank and entrepreneur at a certain fixed ratio. Financial losses are borne exclusively by the bank. The liability of the entrepreneur is limited only to his time and efforts. However if the negligence or mismanagement of the entrepreneur is proven he may be held responsible for financial losses. Mudarabah is usually employed in investment project with short gestation periods and in trade and commerce. Islamic banks mobilize funds on a profit sharing and loss bearing i.e. on Mudarabah basis (PLS). On the liability side, the contract between the bank and the depositors is known as unrestricted Mudaraba because depositors agree that their funds be used by the bank, ay its discretion, to finance to finance an open ended list of profitable investments and expect to share with the bank the overall profits accruing to the bank business. Certain risk are associated with such PLS accounts. These risks are referred to as fiduciary and displaced commercial risk. Fiduciary Risk: The bank shall have in place appropriate mechanisms to safeguard the interests of all fund providers. Where Investment Account holder funds are commingled with the banks own funds, the bank shall ensure that the bases for asset, revenue, expense and profit allocations are established, applied and reported in a manner consistent with the bank’s fiduciary responsibilities. Rate of Return risk and Displaced Commercial Risk: Banks are exposed to rate of return risk in the context of their overall balance sheet exposures. An increase in benchmark rates may result in the investment Account holder having expectations of a higher rate of return. Rate of return risk differs from risk in that banks are concerned with the result of their investment activities at the end of the investment-holding period. Such results cannot be pre-determined exactly. A consequence of rate of return risk may be displaced commercial risk. Banks may be under market pressure to pay a return that exceeds the rate that has been earned on Risk Factors Relating to Islamic Mode of Investment………………………………….57 assets financed by the investment account holder when the return on assets is under- performing as compared with the competitors’ rates. In such case, banks may decide to waive their rights to part or its entire Mudarib share of profits in order to satisfy and retain its fund providers and dissuade them from withdrawing their funds. Calculating Risk Weighted Assets (RWA) for Credit Risk Credit risk is defined as the potential that a bank’s counterparty will fail to meet its obligations in accordance with agreed terms. Investment (Credit) risk exposures in Islamic financing arise in connection with accounts receivable in Murabaha Contracts, Counterparty risk in Salam Contracts, Account receivable and counter party risk in Istisna Contracts, and Lease payment receivables in Ijara Contracts, and Sukuk held to maturity (HTM) in the banking book. Bai-muazzal contract and Higher Purchase under Sirkatul Melk (HPSM) mode in connection with installment payment receivables under HPSM agreement/contract may be added for credit risk exposure in connection with account receivable. In these investments Credit risk will be measured according to the Standardized Approach of Basel II as discussed bellow except for certain exposures arising from investment by means of Musharaka or Mudaraba contracts in assets in the banking book. The assignment of risk weight (RW) shall take into consideration the following components : a) The credit risk rating of a debtor, counterparty, or the obligor, or a security, based on external credit assessment and their RW as stated in Table-2 . b) The credit risk mitigation (CRM) as stated in chapter 5 c) Types of underlying assets that are sold and collateralized or leased by the Islamic banks d) Amount of specific provisions made for the past-due portion of accounts receivable or leased payments receivables The Islamic banks will nominate the external credit assessment institutions (ECAIs) recognized by BB. Risk Factors Relating to Islamic Mode of Investment………………………………….58 Credit Risk Mitigation The exposure in respect of a debtor, counterparty or other obligor can be further adjusted or reduced by taking into account the credit risk mitigation (CRM) techniques employed by the Islamic Bank while collateral received is eligible financial for mitigation on the basis of adopting haircut formula or a guarantee as described in paragraph 5 (5). The Islamic Bank may consider the resultant net exposure applying the haircut formula. The Standard Supervisory Haircuts weight to offset its credit exposure is stated in Table 6&7. Off-balance Sheet Exposures Off-balance-sheet items under the standardized approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF) as stated in Table 3, 4 & 5. The resulting credit equivalent amount will be multiplied by the risk- weight associated with that counterparty credit rating as described in Table 2. Other clarifications and definitions in this regard are described in the paragraph 5(4). Some fixed Risk Weights based on Preference of Underlying Assets The RW of a debtor, counterparty or other obligor shall be reduced and has been fixed by BB on the basis of preferential treatment for some underlying assets where counterparties could be categorized as Retail and Small, or assets could be defined as Residential real estate (RRE) or Commercial real estate (RRE) as clarified in the section 5. The RW will be assigned as stated in the table 2. Past Due Receivables In the event that accounts receivable become past due, the exposure shall be risk- weighted in accordance with the statement of table-2. The exposures should be risk weighted net of specific provisions. Risk Factors Relating to Islamic Mode of Investment………………………………….59 Calculating Capital Charge for Market Risk Market risk is defined as the risk of losses in on- and off-balance sheet positions arising from movements in market variables i.e.